Comptroller Dugan Urges Regulators Around the World To Set Minimum Mortgage Underwriting Standards

TOKYO — Comptroller of the Currency John C. Dugan said today that regulators around the world should address the problem that sparked the financial crisis of the past two years by establishing minimum underwriting standards for all mortgages made in their respective countries.

These standards "would be the true minimums that we believe must be observed to keep lenders from risking too much loss to both themselves and their customers," he said in a speech to a seminar on international banking and finance sponsored by the Japan Financial News Company. "These standards would not dictate every underwriting feature of a mortgage product; instead, they would focus on core practices of sound underwriting on which there is the broadest consensus."

The Comptroller added that these standards should not be the same everywhere in the world.

"Each country has its own unique credit culture and different approaches to mortgage financing, and what works well in one might not work well in another," Mr. Dugan said. "What I am suggesting, though, is that each country should articulate what those standards are for their lenders, and should report periodically on how well those standards are working."

In the United States, for example, at least three underwriting standards should be mandated:

Verification of income and assets. Low- and no-documentation mortgages have performed extremely poorly in terms of delinquency, default, and foreclosure, he said. Not only do they invite misrepresentation and fraud, but these mortgages materially distort the integrity of other underwriting standards that rely on accurate measures of a borrower’s income. "Regulators should consider prohibiting this practice except in very, very limited circumstances where it clearly can be justified," he said.

Meaningful down payments. As house prices rose, lenders responded by allowing lower down payments. With defaults low, lenders and investors then began to tolerate "no-money down" mortgages. "The effect has been pernicious," the Comptroller said, noting that OCC data shows borrowers are much more likely to walk away from loans where they have none of their own money – or "skin in the game" – invested in the mortgage. Mr. Dugan said it will not be easy to decide how large a down payment is appropriate, since too high a requirement would result in many creditworthy borrowers being turned down for a mortgage. "We will need to exercise great care in striking that balance," he said.

For mortgages with monthly payments that increase over time, qualifying borrowers on their ability to afford the later, higher payments rather than just the initial, lower payments. Too many "nontraditional" mortgages were structured so that payments were low at first, but increased over time, and sometimes very sharply. Mr. Dugan said that borrowers qualified at the lower initial rate often couldn't afford the higher payments. "That is the type of underwriting practice that generally should be prohibited, because it often implicitly relies on house price appreciation as the ultimate source of repayment of the loan – and as we have learned all too painfully in the last two years, house prices can certainly go down as well as up," he said.

"We also should generally prohibit the lowering of monthly payments through so-called 'negative amortization' mortgages, which have performed terribly," Mr. Dugan added. "These mortgages lowered initial monthly payments by allowing borrowers not to pay the full amount of interest due, with the unpaid interest added to the principal balance of the loan. Borrowers should not be allowed to dig deeper into debt with each monthly payment."

In addition, Mr. Dugan said it is critical that any new mortgage regulations apply to all providers in order to prevent the kind of competitive inequity and pressure on regulated lenders that eroded safe and sound lending practices in the past.

The Comptroller said that with house prices sharply increasing in recent months in some countries, this is a good time to address mortgage underwriting. The Joint Forum, an international regulatory group that he chairs, has been asked to provide recommendations to the Financial Stability Board to address differences and gaps in the regulation of financial services around the world. One set of recommendations under consideration involves minimum mortgage underwriting practices, he added.

Mr. Dugan said he is normally much more comfortable with markets establishing the terms for credit extension by willing lenders to willing borrowers, with supervisors focusing on lenders’ ability to manage the credit risks they assume, and on lenders’ compliance with consumer protection laws.

"But sometimes, when underwriting standards get so out of balance that they cause widespread damage to borrowers and lenders alike, it becomes necessary for regulators to act more prescriptively," Comptroller Dugan added. "If ever there was a demonstrated need for such intervention, the searing U.S. mortgage market experience of the last several years fits the bill."